Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Thursday, June 06, 2013

House Panel Examines Role of Proxy Advisory Firms, Former SEC Chair Pitt Testifies

Hearings before the House Capital Markets Subcommittee
revealed a growing consensus that proxy advisory firms have become the de facto
standard setters for U.S. corporate governance and need to either adopt best
practices and core principles or be regulated by the SEC. Subcommittee Chair
Scott Garrett (R-NJ) emphasized that Congress must ensure that the proxy system
works for US investors. The proxy system and the distribution of proxies have
become quite complicated and many investors have come to rely exclusively on
the recommendations of proxy advisory firms to vote their shares on proxy
questions. Chairman Garrett analogized the growth in the influence of proxy
advisory firms to the rise of the use of credit rating agencies before the
financial crisis.

Proxy Advisory Firms. Chairman Garrett also mentioned
that SEC staff interpretations have essentially allowed institutional investors
to outsource their proxy voting duties to supposedly independent proxy advisory
firms. The result is that proxy advisory firms currently wield an enormous
amount of influence over the proxy voting process. The Chair also remarked on
the conflict of interest issues around proxy advisory firms. They have no duty
to provide advice in the best interests of shareholders and do not factor
shareholder value into their recommendations. All that said, Chairman Garrett
said that proxy advisory firms serve a valuable role in corporate governance,
but should not be enshrined as sole guardians of proxy corporate governance.

Rep. Brad Sherman (D-CA) said that the real battle is
between crony capitalism and free market capitalism, which demands that
shareholders need good advice and freedom from frivolous lawsuits. Shareholders
should not be deprived of proxy advice, he reiterated. Rep. Sherman fears that
we are moving to the lowest common denominator on shareholder right, adding
that Congress must ensure that shareholders have the information they need and
have the protection that a well-drafted corporation statue can provide.

Rep. Robert Hurt (R-VA) noted that proxy advisory firms must
be sufficiently transparent and accountable. As the SEC has acknowledged, he
observed, there can be conflicts of interest when proxy advisory firms provide
recommendations and other services, such as management consulting services.

Rep. David Scott (D-GA) said that, given the many recent
failures of corporate governance, it is imperative that Congress examine all of
the issues around which proxy advisory services make recommendations. He also
queried why only two companies, ISS and Glass Lewis, handle 97 percent of the
proxy advisory market. Rep. Scott is, like other members of the subcommittee,
concerned about proxy advisory firms providing consulting services in addition
to proxy voting recommendations, thereby leading to potential conflicts of
interest. He questioned what policies and procedures proxy advisory firms
employ to ensure that their recommendations are independent and not influenced
by any consulting fees that they get from issuers. Rep. Scott further noted
that the SEC has not taken any action in the wake of the staff study.

In his testimony,
former SEC Chair Harvey Pitt said that proxy advisory firms exercise extensive
but unfettered influence over corporate governance and indeed have become the
de facto arbiters of U.S. corporate governance. They are powerful but
unregulated, he added, and serious conflicts of interest permeate their
operations.

Chairman Pitt emphasized that effective and transparent
corporate governance encouraging meaningful shareholder communication is
critical. Informed and transparent proxy advice can help corporate governance
only if the advice being provided is solely motivated by the advancement of the
economic interest of investors.

Eschewing federal regulation of proxy advisory firms,
Chairman Pitt, testifying on behalf of the U.S. Chamber of Commerce,
recommended the adoption of industry best practices and core principles. The
Chamber has suggested best practices, he noted, and these are standards that
the industry should embrace and follow. He urged the SEC and the institutional
investor community to lend support to a code of best practices.

Chairman Pitt also testified that two 2004 SEC no-action
letters, ISS and Egan-Jones, had the legal effect of permitting registered
investment advisers to rely exclusively on a proxy advisory firm‘s general
policies and procedures pertaining to conflicts of interest, as opposed
to any specific conflicts a proxy advisory firm might have with respect to a
particular issue or a particular company about which the proxy advisory firm
might make a recommendation to determine if the proxy advisory firm was
independent and could be relied upon to cast a vote for the investment adviser,
without the adviser being deemed to have violated Rule 206(4)-2 of the
Investment Advisers Act or any other provision of the federal securities laws.
Earlier this year at a Chamber event, Chairman Pitt had said that, taken together, the two no-action letters create a
regulatory environment in which portfolio managers believe that if they
outsource the proxy vote they have avoided major problems under Rule 206(4)-6
and their own fiduciary obligations.

Picking up on Chairman Pitt’s point that many institutional
investors have essentially outsourced their proxy votes to proxy advisory
firms, Chairman Garrett asked who is the fiduciary duty owed to, to which Mr.
Pitt replied the fiduciary duty remains with the institutional investors. They
cannot divest themselves of it, he said, adding that the NALs are the vehicle
by which they try to outsource the duty. To Chairman Garrett’s question of
whether the proxy advisory firm has a duty to investors, Mr. Pitt responded
that the firms have a duty akin to fiduciary duty, a duty of truthfulness,
which is not the same as a fiduciary duty.

Testifying on behalf of the Society of Corporate Secretaries and Governance Professionals,
Darla Stuckey, referring to the SEC concept release, said that proxy advisory
firms are one of the few participants in the proxy voting process that are not
generally required to be registered or regulated by the SEC. There is no
accountability by proxy advisory firms even though, given the current structure
of the proxy system, they control anywhere from 20-40% of the vote collectively
on routine matters at widely held companies. When proxy advisory firm
recommendations come out, large blocks of votes are cast almost immediately in
automated voting decisions. These ripple out both from clients that follow the
main policy of each advisory firm, she noted, and those that have so-called
custom policies that are tweaked based on simplistic mechanical inputs.

While proxy advisory firms are not beneficial owners of any
company’s shares, reasoned the corporate secretaries society, the two
largest proxy advisory firms each effectively control a portion of the vote
that is much larger than the Schedule 13D threshold (5%), and even larger than
the 10% affiliate status threshold, yet they are not subjected to any kind of
regulatory regime. The Society pointed out that proxy advisory firms may
produce reports with material misstatements and omissions without any legal
consequences for the firm.

Similarly, proxy advisory firms’ voting policies are also
unregulated. There is no regulatory regime that governs the manner in which
these firms develop their policies or form the recommendations they make. The
policy development process at proxy advisory firms is not sufficiently
transparent, contended the Society, and it is not clear who actually
participates in the process.

The Society believes that proxy advisory firm voting
influence undermines the integrity of the voting system for a number of
reasons, including that proxy advisory firms are subject to conflicts of
interest and make factual mistakes in their analysis, with the effect that their
voting guidelines are erroneously applied to the company’s proposal and the
voting recommendation is inaccurate. Proxy advisory firms are actually subject
to four types of conflicts of interest, maintained the Society. The first
occurs as a result of proxy advisory firms selling services to both
institutional clients and issuers. The second conflict arises when proxy
advisory firms make favorable recommendations on

proposals submitted by their own investor clients. The third
conflict stems from proxy advisory firms’ interest in recommending certain
proposals that are likely to expand their influence and future market. The
fourth may arise when an owner of a proxy advisory firm takes a position on a
proxy voting issue and the firm also issues a voting recommendation on that
issue (this applies to Glass Lewis only since it is owned by a major public
pension fund).

The Society recommended that proxy advisory firms be
required to become registered investment advisors. In this way, the practices
and procedures of such firms would be subject to SEC examination, which should
provide additional discipline and accountability to the system. Once
registered, proxy advisory firms would need to establish to an oversight
authority that they are following their procedures and would need to provide
factual support for the bases of their disclosures.

In his testimony,
former SEC Chief Accountant Lynn Turner said that in today’s global markets an
asset manager may invest in dozens of capital markets, and in thousands of public
companies. For example, at Colorado PERA, the fund makes and manages

investments on a global basis in 7,000 to 8,000 companies.
The proxies for these companies may involve the election of numerous directors,
approval of compensation and acquisitions, shareholder initiatives submitted
for shareholder approval, and any number of additional matters.

Many mutual or pension funds do not have unlimited staff who
can read thousands of proxies and then research and submit an informed vote on
the issues as required. Mr. Turner said that it would take well over a hundred
staff, at a very significant cost to vote 8,000 proxies in a global market
place. That would be a cost that would have to be passed on to investors, he
noted, significantly increasing their fees, and reducing their investment
returns, and ultimately, the amounts they are trying to save for retirement.

Instead, the funds rely, in part, on research they can buy
from ISS and/or GL or others, along with their own research and proxy voting
guidelines, to make a decision on how to vote.